Macroeconomic and financial market commentary

As time goes by.

The human race is an inherently emotional species. We were told that our origins are to be found in the “homo sapiens”, but, regrettably, no definite proof has been found. What’s more, anecdotal evidence piles up every day to suggest otherwise. We still have a ways to go before peak knowledge, but peak wisdom is, without doubt, something of the past. Let’s see if we can make wisdom a bullish market again, sometime after this effervescent madness settles down.

Herd behaviour, groupthink, and emotional conduct, are the pillars of our daily activities and desires. That is the main reason to be mindful of the consequences of shouting “fire” in a crowded cinema. Not one out of every ten will try to corroborate the information. Provoking stampedes is easier with humans than it is with Buffalos. Herd and human behaviour are becoming a synonym.

Politicians are aware of that, so they talk soft, and use whatever information they get from the market (well, nowadays the daily price fix of goods or investments that simulates a market), or society, to their convenience. And their convenience is “extending and pretending, as much as they can, for as long as it lasts”. They are not wise or honest, but they are not stupid either.

Politicians and Central Bankers are cognizant of the structural weaknesses of their model. They know the issues that can spoil the “extend and pretend common knowledge” game they are in:

Inequality and the ensuing social upheaval to cater for.

A domino of debt write downs, if the sustainability and thus validity of debt as an asset in balance sheets, is put to question.

How are they handling them?

Inequality and poverty have to be kept at bay. Entitlements and welfare are the drug that masks the symptoms of a notoriously unfair society. They can’t afford to mark them down to market (tell society that there is no way that the actual economic output will be able to finance those future costs, and has to lower them).

Debt has to be perceived as sustainable, so they have to print to death, and preserve the ZIRP and NIRP environment that keep the financial costs of the unpayable debt as low as possible. Printing also collaterally serves the purpose of helping finance the subsidies and welfare they need in order to ward off public protest and violent mass behaviour.

Markets have to be tamed (read supressed), to prevent their instability, and continue to keep alive the positive message embedded in the common knowledge game: CB’s will assure us endless prosperity no matter how much they have to print, or NIRP around. Or do whatever it takes.

Volatility and risk premiums should be outlawed, and while they are at it, supressed in practical terms.

Greece is the poster child for the developed world. In a nutshell, the second Versailles treaty in history is the victory of the policies that protect the second issue (debt sustainability), versus policies that protect the first (subsidies and entitlements well above society’s means). It’s not that one flank is more strategic than the other. The real Greek drama is that debt sustainability is in the interest of creditors, while fairness and social peace is in the interest of common people. Needed to know who would prevail?

It is to be expected that, in exchange for conceding to “extending and pretending” the sustainability of Greek debt, creditors are aware that they will have to give the mob some “bread and butter” in order to feed them, and pay for the maintenance of the status quo. Let’s hope there is still some memory cells left in German brains. I doubt it. Human memory is short lived. I expect no more than a few token financial aid kits. It would be the same result, the other way around, because magnanimity and wisdom usually pair together, and we are definitely short of them both, regardless of who happens to be at the top of the food chain at that particular time in history.

Greece is a basket case, and so are the rest of the heavily indebted sovereigns, only further down the road (Greece is really an extreme case within the theoretically developed countries).

As I said months ago, Central Banks and politicians have no other options left. Fiscal profligacy and entitlements (even absurd ones) are needed to keep the masses calm. And we have to finance our outstanding debt, and even place more and more of it. So we need at least ZIRP, or something close to it, to chug along.

In a parallel development, inequality gets worse, so we need more and more entitlements, even as we evolve towards an extreme “winner takes it all” economy.

And we have to keep animal spirits working, so we have to manipulate markets and do “whatever it takes” (Copr. Mario Dragui), to make everybody think that the debt parked in our balance sheets is real, and has some economic value left.

Dismally, it’s not the Martians that hold that debt in their books, but financial institutions around the world -a substantial part of it. Of course it is valued at par (no mark to market for sovereign debt held to maturity). No risk there to be valued in the stress tests. Financial faith in sovereign solvency goes further than most religious extreme convictions. Banks, insurance companies and pension funds will take a tremendous hit when debt is marked to real market value (adjusted for solvency expectations).

I am a very strong seller of all financial sector corporates that are exposed to sovereign insolvency. Politicians might finally reflate depositors out of trouble, but equity holders will be massacred. Greek banks proved the point just a week ago.

For equities as a whole, I also think it is an outright short. Creditors will be bailed in to pay for the accumulated debt, but corporations will have to cope with the plunge in aggregate demand that follows. A substantial load of entitlements for the future (that are being paid with printed money right now) will also be financed from their P&L account.

In Greece this has gotten to a point where nobody believes the story.Not even the IMF (what a surprise!) accepts the sustainability of their debt overhang. Deep recession and the ensuing inequality and poverty have also degraded common sense in Greece. The poor (Greeks) resent the rich (Germans) for the “winner takes it all” euro model that has made them poor, while Germany increased its commercial surplus. The Germans feel they represent the Aryan race (an ideological leftover) and financial orthodoxy, and resent a de facto fiscal paradise with entitlements even superior to their own. Their initial solidarity feelings have naturally faded five years later. The trouble is, both Greeks and creditors, have a point. It’s the euro business model that doesn’t work.

The Greek welfare state is unsustainable, more so as they stubbornly try to hang on to large pensions and entitlements, together with fiscal deficits (with a defunct fiscal system). Other governments understandably cannot accept this. Across the bargaining table, creditors are not willing to compromise a dime of their credits to obtain a quid pro quo stabilization of the Greek fiscal stance to acceptable standard levels of our time (levels that are way too high anyway). A lose-lose situation, anyway you look at it. For some the nominal value of their credit is an “untouchable”, for the others, social peace and some sort of economic justice is a must.

Both sides support an untenable position. Welfare has to be indexed to GDP (you cannot use fiscal profligacy as a permanent population doping tool). And debt has to be written down to sustainable levels. High untouchable debt levels (or reparations) take us … We all know where they takes us. We all remember were Versailles I took us. Is Versailles II going to be an entirely different story?

Debt has to be “greeked”, not just in Greece, but everywhere. Creditors beware: that is not just an ordinary haircut, it varies with the debtor, but globally comes real close to the Dalai Lama hair style. Or else, it will happen anyway at some point -in a disorderly way. Needless to say, assuming debt relief, and trimming welfare, are both non-starters for creditors and landlords, and for the mob and their representatives (Syriza, Podemos etc etc). So here we are, extending and pretending once again. I’m going to apply for an actor’s studio summer seminar. Or maybe a simple webinar will do the trick -everybody is willing to believe the “extend and pretend” story.

I find myself therefore saying once again that our global non-consolidated balance sheet (if you consolidate, you net out the debt like Heli-Ben loves to say) is hopelessly unsound. Assuming that debt doesn’t matter because it nets out is the Guiness record for “naïveté”.Take my word for it -debt will have to be written down to a substantial extent. And, once again, it bears repeating that we have only two ways left out of this mess -Great depression style, or Weimar-Zimbabwe-Argentina style. Lastly, you will have to forgive me for persisting in the hypothesis that it will be deflation first, then hyperinflation. In Barton Biggs lexicon, it will be first ice, then fire. It is not a high confidence call, because none in the behavioural economics area is, but at least it’s a call. I stand by it.

When, is obviously an entirely different beast. We have to leave that as a wild card and wait and see, even as time goes by (inoubliable Ingrid Bergman, unforgettable song indeed). The whole film was premiered well before before peak wisdom. The quality of the script is outstanding.

Ok, if you had the time to enjoy the scene or the music, it’s back to earth. We just have to go deeper into the debt write down procedure, because it is sure to affect, one way or another, all the population with finacial assets in their balance sheet.

“Comme cela a toujours été le cas”, only when the world at long last had to admit that we had accumulated a great debt overhang (back in 2008) that was generating chaos in the market, we switched into “action mode”. We kinda sorted out the payable from the unpayable, and decided to bail out the creditors (Banks, Fannies and Freddies, AIG, Merryl, Goldman, most of the Spanish banking system, the French and German banks -with a private to public holding of Greek debt swap-, and a ten thousand corporation long list). It was just Bear Sterns and Shearson’s bad luck that they happened to come first, the problem was not yet systemic, and were thus left to die. Everybody else and their dog were “bailed out”.

In essence, a “bail-out” is a fancy word to say that it was tax payers who paid for the write downs. It was most frequently done by exchanging private debt, or equity (the GM or Ford case), for public debt, or freshly printed money (increasingly there the two concepts are becoming the same). Bail outs did not have time to be a fad, they came “out of the blue” to overcome the fashion phase, and become a new way of conducting business. Corporations geared up and, when necessary, they were bailed out by the tax payer.

As Bob Dylan said, “the times they are a changing”. Thank God, we always keep moving -pity it is not always in the best direction. And new fads emerge, then they become fashion, and finally we have a trend or a standard procedure. Sometimes ideas even morph into a “universal truth” -eg., that God will save all the members and believers of the Keynesian-Princeton sect. But there isn’t that many of those universal truths. Believing in God and JM Keynes are probably the top two today.

The new fad is definitely “bail ins”. They gave it a first shot in Cyprus. It will end up being real in Greece (Versailles II treaty only gained some extra time once again). And it is the likely regime in most of the write debt write downs of the future. If only because bail outs have become a social and economic impossibility. Debt ridden states can no longer afford to bail out anybody. They are likely the next to fall. And I doubt Germany or any other of the safe haven countries are going to bail anybody out. In fact, bail in’s are becoming compulsory, at least in Europe (see Reuters note).

Yes, the implications of what I just wrote are clear. Your money is no longer safe in banks that hold sovereign debt of peripheral, prone to default, states. And it is also no longer safe in banks that have substantial credit assets against the population of countries that can default.

Same thing for pension funds and lifetime savings. You have to be extremely cautious when parking your money in one asset or another. All balance sheets of financial institutions are suspect, because they hold assets that could, and will at some point, get marked down brutally.

Of course, within this scenario you have different banks and different countries. Some pension funds are more risk averse than others. But everybody’s money is on the hook when we mark all those balance sheet assets to market (to a real long term sustainable market price). More frequently than not, that debt is worth much less than par. Mario Dragui knows that well. He did all it takes to manipulate that value upwards.

They can’t manipulate for ever. At some point, hyper-inflating the economy to devalue outstanding debt will be the last alternative option, so on the other side you want to avoid long duration at locked in low rates just in case.

It is very tough to be an honest asset allocator at this time.You can go with the herd and assume nothing systemic will go wrong (despite evidence mounting up against you). Or you can prepare for the debt write down, and suffer ignominy in the meantime. Not an easy choice.

I will be sailing the “Copa del Rey” in Majorca for the next few weeks (boat transport, crew training, boast tuning and finally racing). Next post hopefully by mid-late august. I doubt anything will have changed much before then. Low volume markets are easier to control by POMO desks. Any fireworks should be delayed till September at the very least. Enjoy your holiday. After all, “On aura toujours Paris”.